Huge Hidden Potential in Natural Gas

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For investors, the natural gas market seems loaded with opportunity. Energy demand is increasing around the world, and the U.S. appears to have a stranglehold on a clean, cheap resource.

Because of oversupply and plummeting prices, however, investors should look beyond the traditional exploration and production companies. Forget about predicting a price bottom, analyzing reserves, and calculating break-even points. To tap into this potentially lucrative commodity, focus on the lesser-known suppliers and the companies making huge investments that will pay off in the long run.

An all-in wager by production companies
Before betting on the future of natural gas, investors need a primer on the past. In recent years, natural gas interest surged as drilling techniques exposed the huge deposits found in U.S. shale formations. Production companies arrived at the scene and kicked off the so-called "natural gas revolution." A revolution, for all intents and purposes, that was supposed to deliver huge profits.

Years later, those profits have been slow to materialize. In a classic lesson of Economics 101, the surging interest in natural gas drove supply upward, and prices downward. Natural gas now trades around $2.60 per million BTUs, 45% below the year-ago price.

Unsurprisingly, the new commodity on the block has lost some of its allure.

Earlier this year, the second-largest producer, Chesapeake Energy (NYSE: CHK  ) , announced that it would shift production away from natural gas in Texas' Barnett Shale to explore opportunities in more profitable natural gas liquids. Southwestern Energy (NYSE: SWN  ) , a low-cost leader in Arkansas' Fayetteville Shale, followed suit.

Southwestern's CEO, Steven Mueller, noted that reductions in the capital budget would occur if the oversupply continued in the years ahead. In Mueller's words, "The rig count on the gas side has been dropping like a rock."

Over time, production will slow down, and weak operators will abandon their natural gas rigs. Prices should recover, but will investors have the patience?

Hidden value in suppliers
Instead of betting on a natural gas rebound, investors can find value in an under-the-radar oil and gas equipment supplier. After all, the extraction of hydrocarbons from the earth will continue in the foreseeable future, whether the underlying resource is a liquid or a gas.

Rig operators like Helmerich & Payne (NYSE: HP  ) provide great exposure to the drilling boom currently under way. The Oklahoma-based company nearly tripled its market share over the past decade, and became the leading operator of land rigs in the U.S. In 2011, Helmerich announced over 70 rig build-outs, more orders than the combined total for competitors Nabors and Patterson-UTI Energy. Further, the company experienced a 46% jump in profits in the most recent quarter on a revenue increase of 25%.

Helmerich's shares look inexpensive when you consider the current trading price of 11 times forward earnings. Furthermore, the company has a low debt-to-equity ratio of 0.7, despite substantial investments in rig construction over the past few years. Helmerich's strong competitive position and reasonable share price make it an attractive energy stock in my book.

A promising outlook for natural gas transport
While the price ratio between oil and gas has grown dramatically (it's currently 40 to 1!), new markets for the gaseous fuel will cause this discrepancy to shrink over time.

One company paving the way to a natural gas future is Westport Innovations (Nasdaq: WPRT  ) . Westport designs natural gas engines and teams up with manufacturers like General Motors, Ford, and Cummins to bring these engines to market.

On top of a remarkable year for Westport in 2011, the company should get a boost due to President Obama's recent endorsement of natural gas transportation. The president announced a proposed tax break for natural gas-powered trucks that could jump-start mass production, stimulate spending on necessary infrastructure, and hopefully, ultimately, create new jobs.

Will the proposed tax break serve as a catalyst for Wesport's share price? Only time will tell, but I remain bullish. Westport currently stands on the forefront of alternative energy (the company has very few notable competitors) and thus generates consistent revenue growth of over 30% year after year. An uptick in demand for Westport's engines should pay off in substantial profits down the road.

A long-term bet on exports
The shale gas boom has burdened producers with excess supply in the U.S., so delivering natural gas to foreign markets seems like a logical solution. Prices remain high in many overseas markets, but the problem is the lack of domestic infrastructure.

On this front, Cheniere Energy (AMEX: LNG  ) is invested in a liquefied natural gas (LNG) export terminal that could direct the U.S. reserves to foreign countries. Based in Houston, Cheniere has made headlines due to multiple deals with foreign purchasers. By 2015, Cheniere Energy plans to export 2 billion cubic feet of gas per day from a Louisiana facility known as the Sabine Pass Terminal. As the fastest-growing component of the global natural gas market, LNG's popularity will only increase around the globe. Currently there are 25 LNG-importing countries outside of the U.S., and Cheniere is poised to tap into these markets.

Foolish takeaway
The natural gas industry currently offers something for everyone. My suggestion is to find the companies with minimal exposure to the huge price swings of the underlying commodity. Thorough research will reveal the undervalued suppliers and cutting-edge companies that could prosper for decades to come.

Besides the companies mentioned above, I recently came across a leading equipment manufacturer that will benefit from the oil and gas boom. Feel free to learn more about this thriving company by reading "The Only Energy Stock You'll Ever Need." Click here to find out why our analysts believe this company has "growth prospects rich as Texas tea."

Fool contributor Isaac Pino does not own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFBoomer

The Motley Fool owns shares of Ford Motor. Motley Fool newsletter services have recommended buying shares of Westport Innovations, Ford Motor, General Motors, Chesapeake Energy, and Cummins. Motley Fool newsletter services have recommended writing puts in Southwestern Energy. Motley Fool newsletter services have recommended creating a synthetic long position in Ford Motor. 

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 02, 2012, at 12:59 PM, prginww wrote:

    Be very careful with LNG. Just last week the U.S. Energy Information Administration came out with a study saying that exporting liquid natural gas would raise domestic natural gas prices 20-30%.

    The government is already receiving pressure from US manufacturing groups to halt the export of liquid natural gas to keep domestic prices down. I think we can see a lot of regulation from the government that will put a halt to or create a lot of boundries to the the exporting of liquid natural gas.

  • Report this Comment On February 02, 2012, at 2:26 PM, prginww wrote:

    I'm not so sure that manufacturing groups will get their way in this one. Even if they do win and get laws that prohibit the export of LNG, it only delays the inevitable.

    Prices must rise. The price point is already so low that gas drillers arent drilling anymore. They wont start drilling again until they can make a profit from new wells. Demand will come online slowly as the price remains low, and in addition, supply will decrease. This will lead to the price rises that will allow drillers to start drilling again.

    If, on the other hand, drillers are allowed to export, prices rise sooner, as supply is removed from the market. The drillers make profits, which allows them to keep drilling.

    Price is going to go up either way, its just a matter of time.

  • Report this Comment On February 03, 2012, at 10:50 AM, prginww wrote:

    I don't think it matters if the manufacturing groups get their way in the end. If the government gets involved and delays the export of liquid natural gas then a company like LNG with so much debt on the books is going to be in a lot of trouble.

    They won't be able to survive a long term government review or delay. They aren't scheduled to start exporting till 2015 and it can't come soon enough with their debt load.

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